Chapter 4 Part 3: Private Debt, Real Estate and Other Alternative Assets
This is the final piece of Chapter 4. We covered venture capital, growth capital, LBOs and special situations before. Now Demaria walks us through the rest of the private markets universe: private debt, real assets, and a handful of other instruments that sit at the edges of the asset class.
Private Debt: When Banks Say No
Private debt funds step in when regular banks will not lend. After the 2008 crisis, banks pulled back from lending to small and mid-sized businesses. New regulations like Basel III made it more expensive for banks to carry these loans. So fund managers filled the gap.
Direct lending is the simplest version. A fund lends money to a company for a specific purpose, like launching abroad or making an acquisition. Unlike a bank that just runs a credit score, these fund managers actually do proper due diligence. They meet the management, study the market, look at competition. It is closer to how private equity works than how banking works.
Direct lending happens mostly in the USA and Western Europe, places with stable legal systems where you can actually enforce a contract in court. By 2017, private debt funds managed about $667 billion total, with direct lending raising $52.6 billion that year alone.
Unitranche is a fancier version. It bundles senior, junior, and mezzanine debt into one single package. Less paperwork, more flexibility. Expected returns sit around 9-11% gross IRR.
Mezzanine Debt: The Middle Child
Mezzanine debt is the interesting one. It sits between regular debt and equity. The lender gives money, charges higher interest than a bank would, and gets repaid all at once at the end (called “in fine”). But here is the kicker: the lender also gets the option to convert that debt into equity. So if the company does really well, the lender can switch from being a creditor to being an owner and share the upside.
This makes mezzanine popular on both sides. Lenders like the higher interest plus conversion option. Borrowers like not having to make repayment installments during the holding period.
Target gross IRR for mezzanine is 15-18%. Second lien debt, which is basically mezzanine without the conversion rights, aims for 10-12%.
One thing Demaria spends time on is covenants, the rules written into loan contracts. Before 2008, “covenant light” loans became trendy, meaning fewer restrictions on borrowers. When the crisis hit, defaults spiked 3.6x between 2007 and 2008. Banks tightened up. But as soon as the crisis faded, covenant light came right back. Low interest rates make investors hungry for yield, and hungry investors accept worse terms. It is a cycle that keeps repeating.
Distressed Debt: Buying Trouble on Purpose
Distressed debt funds buy the debt of companies that are failing, usually at a big discount. There are two flavors. Hedge funds do “debt-for-trading,” just buying cheap and selling when the price recovers. Private debt funds do “loan-to-own,” where the goal is to actually take control of the company by converting debt to equity, then restructure it back to health.
This whole strategy depends heavily on bankruptcy law. The US Chapter 11 system is basically built for this. It freezes all debt payments, puts a judge in charge, and lets creditors force a restructuring plan even if some people disagree. If you buy enough of the right debt tranches, you can take over the company.
Europe is more complicated. The UK has decent creditor protection, with a 92% recovery rate. Germany is at 67%. France is at 56%, partly because French law prioritizes keeping businesses running and protecting jobs over paying back creditors.
A newer twist is non-performing loans (NPLs). After 2008, European banks started selling bad loans at a discount. Funds buy these and then try to recover the money through pressure, restructuring, or seizing the collateral.
Niche Stuff: Venture Debt, Lawsuits, and Planes
Demaria mentions a few niche strategies that are worth knowing about. Venture debt is like mezzanine for mature startups. Interest gets capitalized and the fund gets paid back at a liquidity event. Average net IRR was 11.5% between 2007 and 2012, but the range was wild, from 1% to 60%.
Litigation financing is a fund lending money to cover legal fees. Win the case, the fund gets a share of the payout. Lose, the fund loses everything.
Then there is royalty financing, aviation finance, trade finance. Each uses some asset or future cash flow as collateral. They are small but they exist.
Real Assets: Buildings, Roads, and Trees
Private real asset funds invest in tangible things. The categories map roughly onto the private equity strategies we already know. Greenfield is like venture capital, building something from scratch. Core and value-added are like growth capital and LBOs, buying existing assets and improving them. Opportunistic is like distressed investing, high risk, high reward.
Real estate funds manage about $811 billion. The sub-strategies range from core (buy nice buildings in great locations, minimal work, 15-30% debt, mostly yield-driven) to opportunistic (buy rundown buildings, gut renovate them, 60-80% debt, almost all capital gains). North America is 58% of the market.
Infrastructure is things like toll roads, airports, water systems, power grids. These assets usually have local monopolies, so they are less sensitive to economic cycles. The sector managed $388 billion, with the USA at 38% and Europe at 30%.
Natural resources includes oil and gas (mostly midstream and downstream, to avoid price volatility), renewable energy (solar, wind, biomass), farmland, and timberland. Timberland funds generated a modest 4.2% pooled average return, but they offer inflation protection and low correlation with other assets.
The Supporting Cast: Funds of Funds, Secondaries, and CDOs
Funds of funds were once a popular way for smaller investors to get into private equity. But after 2008, they fell out of favor. The double layer of fees was the main problem, 0.8-1.0% management fee plus 5-10% carried interest on top of the underlying funds’ fees. Big institutions started building their own teams instead. The fund of funds industry responded with co-investment programs, where they invest directly alongside funds at lower fees.
The secondary market is where investors sell their stakes in PE funds before the fund’s term is up. This is important because liquidity is one of the biggest problems in private equity. As this market grows, PE becomes less scary for investors who worry about locking up money for 10+ years.
CDOs and CLOs are repackaged loans sold on financial markets. They had a rough reputation after 2008, but their actual loss rates were low, only 1.9% over 2007-2011 according to Fitch. They came back with stricter rules and better transparency.
Exotic assets like art and wine funds exist, but Demaria draws the line here. If there is no entrepreneur involved, it is not really private equity. It is just buying stuff.
Demaria’s Conclusion
Private markets are a complete ecosystem that can finance a company at every stage. But not every company needs it. Most startups do not need venture capital. Not every ownership transition needs an LBO. Private equity works best when there is a specific need that regular financing cannot fill.
One interesting data point: despite the common criticism, LBOs actually create jobs on average. When a family-owned business gets bought by an LBO fund, employment goes up because the company needs to become self-sufficient before being sold to the next owner.
The chapter ends with a warning about regulation. New rules like AIFMD and Dodd-Frank have raised the cost of starting a fund, which could reduce the number of new managers entering the market. That means less competition and potentially less innovation in how private capital gets deployed.